By Brendan Conway

D.A. Davidson analyst Tim Ramey, until now a bull on the embattled stock, downgraded his investment rating on Herbalife (HLF) to “neutral” from “buy” after allegations of inside trading at KPMG LLC – which leave the company without an auditor and lacking three years of audit reports.

Ramey is a warning of a potentially tricky situation with the company’s loan covenants now that it is without its 2010-2012 reports — predicting those covenants could be breached even if (as appears possible or even likely at this point) the fault doesn’t lie with Herbalife. The upcoming period could be “disruptive to the stock, but hopefully not the company,” Ramey predicts.

After bobbing slightly in negative territory midsession, Herbalife’s stock is now down 5%.

Here’s the summary.

KPMG Resigns as Auditor and Withdraws Opinion – Implications Arise

Downgrading to NEUTRAL

In light of today’s announcement that Herbalife’s former auditor KPMG has resigned and withdrawn its audit reports on Herbalife’s financial statements for 2010, 2011 and 2012, we are downgrading the shares to NEUTRAL from Buy and lowering our price target to $38, previously $78. Our price target is 8x our FY13 estimate $4.75.

There is no reason to feel differently about Herbalife, its prospects, its historic performance, or our outlook. Our EPS estimates are unchanged. Yet as a stock, it will be a serious problem to be out of compliance (through no fault of their own) with NYSE requirements; and potentially breach their loan covenants. We are reducing our long-term target to $90, previously $180 which encapsulates our view that there is heightened risk and volatility near-term, but excellent value in the longer term.

We assume the process of hiring a new auditor will go quickly – maybe days or weeks. However, the new auditor will have to perform its own audit and re-establish its own review of financial controls. We estimate this process could take as long as a year – we guess HLF would be lucky to file their 2013 10-K on time. Given that there is no allegation of fraud or questionable accounting, we doubt the re-audit would be forensic in nature, but if it is, it will take more than a year.

We assume HLF will get an NYSE de-listing notice because of the withdrawn audit opinion; however, we believe it is highly unlikely they will be delisted.

We assume HLF will be in violation of their loan covenants, though they may be able to get a covenant waiver due to these unusual circumstances.

We assume the company will be unable to buy back stock during this period, and doing so would be imprudent given the potential lack of financial liquidity.

This is and will be disruptive to the stock, but hopefully not the company. Herbalife will likely have an excellent cause-of-action against KPMG, and clearly they will have their audit fees refunded for the past three years. But for now it would be imprudent for us to continue recommending purchase of Herbalife’s shares.

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There are 4 comments

APRIL 9, 2013 2:25 P.M.

vandemar1 wrote:

to downgrade a stock because the company's auditor had to leave because of an internal legal situation, makes no sense. As he said, it is not a breach? so why to term it that way, it is confusing and irresponsible. Poor anaylsis of the situation.

APRIL 9, 2013 2:28 P.M.

T.C. Galvin wrote:

What we need to know is whether Scott London was buying or selling HLF based on his insider information...the missing audit reports are a side-show.

APRIL 9, 2013 2:48 P.M.

grnlightnn wrote:

Doesn't matter, The problems caused by this breach are widespread. as the article states. Would you tell people to buy a stock when it is going through issues so intrical to the business it's self as the financials are. After all that is why they are forced to be audited by outside firms. It is part of the integrity of the markets if there is any intregrity.

Don't think Scott was the one using the info he was just providing it to a third party. The real question is... Is the person connected with Icahn or Ackmen?

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Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.